Perspectives. Wealth Planning Strategies on the Eve of Tax Reform

Perspectives S tay inform e d. be empo we red. Wealth Planning Strategies on the Eve of Tax Reform After the smoke started to clear following the results of Election 2016, the debate over its potential ramifications has began. President-elect Donald Trump has made it clear that he wants tax reform, and he wants it as quickly as possible. To help him in this quest, he has a Republican House and Senate who also want tax reform. However, to make this happen, the devil is in the details. Obstacles to tax reform There are two obstacles that will need to be overcome in order to enact tax reform. The first is the Senate road bump. The final count on the political distribution of the Senate is anticipated to be 52-48 in favor of the Republicans. In order to avoid the possibility of filibuster as a tool to prevent tax legislation from advancing, either: eight Democrats will need to get on board to attain the 60 vote Super Majority rule, or the Budget Reconciliation Process will need to be used which allows tax legislation to pass with a simple 51 vote majority. The second obstacle is the resulting decrease in revenues. The 10-year cost of Trump s proposal is estimated by experts to be between $4.4 and $5.9 trillion, with the GOP estimate half of that at $3.1 trillion. 1 But where will offset replacement revenues or expense reductions be found? And how will the parallel proposal of massive works projects to improve infrastructure be paid for? These two issues are likely the only potential drag on the march to tax reform. Many commentators believe the proposed changes to the tax laws will ultimately pass, probably with some compromises. Trump tax reform proposals While Trump and the GOP's versions of tax reform have differences, they also share many similarities. It is safe to assume that whatever proposals we are seeing now will be tweaked before the cake is baked. Here is an overview of the changes proposed by Trump 1 LOWER INDIVIDUAL INCOME TAX As part of Trump s proposal, individual income tax rates would go down. Currently we have seven income tax brackets. Trump s plan has 3 brackets: 12, 25 and 33%. Capital gains rates stay the same 0, 15 and 20%. The GOP proposal for capital gains is to allow a 50% deduction of the gain before the tax is imposed. The Private Bank

As part of the calculation of taxable income, the Trump proposal changes three items: (1) personal exemptions are eliminated, (2) standard deduction is increased, and (3) itemized deductions are capped. The new standard deduction: for single individuals from current $6,300 to $15,000; for married-joint filers from current $12,600 to $30,000. Itemized deductions will be capped at $100,000 for single filers, $200,000 for married-joint filers. We should note that the GOP plan does not contain these caps, rather it eliminates itemized deductions entirely, with the exception of mortgage interest, charitable donations and a few taxes (excluding state income tax). The elimination of personal exemptions may be bad for families with more than two dependent children (2016 personal exemption is $4,050). A family of five with 3 dependent children would see less deduction from the new system. Under the current rules, that family would have a $12,600 standard deduction plus 5 personal exemptions at $4,050 per person, for a total of $32,850. However, under the proposal, they are capped at $30,000. The new standard deduction could negatively impact the benefits of the mortgage interest deduction for middle-class families with mortgage payments and few other itemized deductions. The first $30,000 a year in deductions will have no income tax benefit for a married couple because of the increased size of the standard deduction. 2 CHILDCARE AND ELDERCARE DEDUCTIONS An above-the-line deduction would be allowed for childcare costs for children under the age of 13, and would be capped based on a state average for a child of that age. The deduction would also apply for Eldercare expenses for a dependent of up to $5,000 a year. This deduction would not be allowed for married couples making over $500,000 a year and singles making over $250,000 a year. These benefits would be indexed for inflation. 3 ELIMINATE TAX LOOPHOLE FOR "CARRIED INTEREST" The average American may not know what Carried Interest is, but many have heard the stories of wealthy individuals avoiding millions in taxes by taking ownership in the company they work for in order to ultimately sell and pay capital gains instead of ordinary income. Ordinarily they would have received income and paid ordinary income tax. This is a huge paradigm shift on a contentious issue. Under the proposal, taxpayers who make money this way would have to pay ordinary income tax rates on their gains when the company is sold. 4 LOWER CORPORATE INCOME TAX The corporate income tax rate would be lowered from 35% to 15% with some limitations on deductions. The GOP proposal is 20%. There is uncertainty whether the 15% tax rate also applies to business income that flows through to individual tax returns, if the taxpayer has an active business structured as a pass-through (S corporations, LLCs, Partnerships and sole proprietorships). If this becomes part of the plan, it would create huge incentives for individuals to become independent contractors instead of employees. The proposal also provides for 100% expensing of capital expenditures in the year of acquisition instead of depreciation or amortization. In addition, Trump s proposal would encourage U.S. corporations that keep money overseas (from profits made overseas) to repatriate those assets by having a repatriation holiday (fixed-time period) when those assets could be brought back to the U.S. at only a 10% tax rate (as compared to the current 35% tax rate). Capital Economics reports that, as of 2015, U.S. corporations had over $2.5 trillion parked overseas, including $110 billion by Microsoft alone. The Private Bank 2

5 ELIMINATE THREE TAXES Trump's proposal repeals the 3.8% Net Investment Income Tax, the Alternative Minimum Tax (AMT) for both individuals and corporations, and Estate Tax. Details on Estate Tax repeal The Trump proposal calls for full estate tax repeal. Stepped-up basis for transfers at death would be repealed as well, and instead carryover basis would apply. For example, assume Antonio purchased a rental property many years ago and had taken depreciation, and his basis was currently $100,000, and the fair market value of the property currently $1 million. If Antonio sold the property, he would have to pay capital gains on $900,000, the difference between his $100,000 basis and the $1 million sales price (plus recapture depreciation). Under current law, if Antonio passed away and left his home to daughter Gabrielle, and Gabrielle sold the property for $1 million, she would pay $0 capital gains taxes because she got stepped up basis. If instead she held the property for a couple more years and was then able to sell for $1.2 million, she would pay capital gains only on the $200,000 of appreciation that occurred since her father died. If instead the new law is passed and Gabrielle only gets carryover basis, she would pay the same amount of capital gains tax as her father if he had sold it. However, there is also an argument that what Trump means is that he actually wants to trigger all capital gains taxes at death (similar to the Canadian system). Trump s website vaguely references some break on the triggering of capital gains tax at death for owners of small businesses and farms, without any details. In addition, there would be an exemption taxpayers could use to allocate to specific assets that would allow those assets to get stepped-up basis at the death of the taxpayer: $10 million exemption for married taxpayers; $5 million for single. Presumably a taxpayer (or the representative of their estate) could pick and choose which assets to allocate this exemption to, with the preference being the most highly appreciated assets, while factoring in whether there are any assets never likely to be sold by the heirs. This in turn leads to the conclusion that there would still have to be some kind of Federal estate information return filed to show the allocation of this tax benefit among the assets owned by the deceased. With this system, it would be imperative that a client s estate plan make clear either who benefits from the $10/$5 million and/or who gets to make the decision. The GOP proposal is full estate tax repeal while retaining stepped up basis at death on all assets. What is unclear at this point is whether full estate tax repeal also means full gift tax repeal and generation skipping tax repeal. Trump s proposals to date have been silent on whether estate tax repeal really means the entire system including gift taxes and generation skipping taxes, or literally just estate tax repeal. It is likely that it does include generation skipping tax repeal. There is a split of opinion on whether it also means gift tax repeal; more on this in a moment. Ramifications of Federal Estate Tax repeal, if it passes If the Federal Estate Tax is repealed, estate planning in general will be just as important as before, but with the focus on non-estate tax issues. If Estate Tax repeal is permanent, we can say goodbye to many of our estate tax planning strategies such as new Qualified Personal Residence Trusts (QPRT), Grantor Retained Annuity Trusts (GRAT), Irrevocable Life Insurance Trusts (ILIT) and Intentionally Defective Grantor Trust (IDGT), Sales to Defective Trusts, Fractional Interest Gifts, and Generation Skipping transfers such as Dynasty Trusts to avoid estate tax on transfers to future generations. Strategies used to transfer assets into an irrevocable trust will still be used because trusts still have many benefits including privacy, avoidance of probate, contingency planning for management of real estate and business interests by naming a successor trustee, asset protection benefits for the beneficiaries, and the ability of the gift giver (also known as the Grantor or Trustor ) to control to whom the assets flow to upon the death of each generation of beneficiaries, a feature that is extremely important to many clients. There may also be some benefit to shift income to lower-bracket-beneficiaries. However, even if the Federal Estate Tax is repealed, we won t know whether this is permanent. Might it be reinstated in future years? What becomes of these types of strategies already in existence for our clients? This will become a very careful conversation between the client and their trusted advisors. In reality, there are three options: (1) keep everything that s already been finished because we need to make sure that the if the Federal Estate Tax is repealed, that it is truly final and continues long after The PrivaT e Bank 3

President-elect Trump is out of office, (2) for each strategy, evaluate whether there are any non-tax benefits that make it worth keeping, and (3) for any strategies that are no longer wanted, what are the steps and costs to dismantle and can it even be dismantled? As a final note, the strategy known as an Irrevocable Life Insurance Trust (ILIT) will likely be kept if already created because the death benefit from the policy still transfers to the children/beneficiaries income tax free at the death of the insured(s). Life Insurance is another asset class and represents actual liquid assets that will pass to the children. The important thing is to periodically review the life insurance policy or policies owned by the ILIT to make sure they will still meet expectations at the death of the insured(s). If the gift tax is also being repealed as part of the proposal, there would be no more restrictions on transfers of assets to your family and friends. No more $14,000 limit on annual gifts. So, if you wanted to give your children money or real estate, you could just go ahead and give it to them or to anybody else for that matter. See below for comments on the ability to transfer assets at will as a means to move taxable income into lower tax brackets of family members and whether there will need to be some gift-tax-like rules to prevent this. However, no one yet knows if the tax proposal will eliminate the gift tax or otherwise put restrictions on it such as limiting how much you can gift during lifetime. Charitable planning will still be important and valued. The focus will be on fulfilling a client s wishes and capitalizing on the income tax benefits. Charitable Remainder Trusts will still be attractive for some clients when selling a highly appreciated asset. Private Foundations and contributions to donor-advised funds will remain attractive for income tax planning, subject to the ramifications of the proposed caps on itemized deductions, discussed above, which would limit the amount of income tax benefit in any given year. Keep in mind that any charitable deduction that you cannot benefit from in a given year, can be carried forward for up to 5 years. Also, for clients who are age 70 and ½ or older, you can divert up to $100,000 a year of Required Minimum Distributions from IRAs directly to charity and this would not be impacted by any cap on itemized deductions. As a final note, there is some unclear language on Trump s tax proposal website in the section on estate tax repeal that indicates he wants to disallow contributions of appreciated assets into a private charity established by the decedent or the decedent s relatives. At this point, no one seems to know what this means in the context of an estate tax. If the estate tax has been repealed, what difference would it make where a taxpayer transfers their assets at death? Or is this actually intended to be an actual prohibition on the ability to transfer assets to a Foundation? Again, this issue will need to be clarified. Expect to see up to 3 years of increased activity while clients review the structures they already have set up, decide what they should do with them, and amend their Revocable Trusts to eliminate estate tax provisions. There will be a great need for conversations with our clients after the law passes. It will be extremely important for married clients to review their Revocable Trusts to rethink how they want their trust to work upon the death of the first spouse. There will no longer be a need for Bypass Trusts, Qualified Terminable Interest Trusts (QTIP) which are sometimes called Marital Trusts, and Qualified Domestic Trusts (QDOT) used for spouses who are not a US citizen, but there is likely to still be a need to segregate some of the deceased spouse s assets to ensure they pass to the deceased spouse s ultimate beneficiaries such as children, family, friends and charity. Wealth Planning, which includes estate tax planning, will still move forward. Income tax planning will continue to be essential, and cash flow and retirement planning will be just as important as they are now. Charitable planning will still serve both emotional and income-tax goals. Planning for the sale of a business, business succession and buy-sell planning will also continue to be important, although there may not be any gift or estate tax associated with transferring a business to children. Clients will still have concerns, goals and dreams, and Wealth Planning will continue to help address these. Will the middle class see real benefits from income tax reform? Trump's proposal is positioned to help the middle class. Some interesting observations were recently made about the potential tax savings for a sample middle class taxpayer. 2 Households with an annual income between $143,100 and $292,100 will see an average annual savings of $4,300 under Trump's proposal, and an average annual savings of $300 under the GOP's plan. The PrivaTe Bank 4

Households with an annual income of $3.8 million or more will see an average annual savings of $1.07 million under Trump's proposal, and an average annual savings of $1.2 million under the GOP's plan. Déjà vu? We ve been here before with George W. Bush in 2001 and a Republican House and Senate. Economic Growth and Tax Relief Reconciliation Act of 2001 (EGGTRA) was passed in August of that year. It included the phase out of the Federal estate tax, with full repeal by 2010. The thinking behind waiting until 2010 was that Congress would figure out the numbers before then so that estate tax repeal would be permanent. But they never did figure it out. Or, put another way, they chose not to deal with the issue. So, what's different now? First, the repeal of estate tax has now been on the table for 15 years. Additionally, the public has been convinced it's an unfair tax, even if most people don't pay it. Finally, Trump wants it and he has incredible political capital at the moment. Potential restrictions on lifetime gifts to prevent income tax games? Assuming the Federal gift tax would also be repealed, there would have to be some offsetting legislation to prevent taxpayers from just moving assets into a lower-bracket child or grandchild s name in order to pay less tax on ongoing income or capital gains. We have not seen any proposals on this yet. Might we get a rule that limits how much you can transfer during your lifetime? And might there also be a rule that requires any assets moved within a certain period of time still have income taxed at the gift giver/transferor s tax bracket? More clarity is needed There are a number of other questions that don't have a clear answer yet. These questions include: 1 2 Will the new law, if passed at any time in 2017, be retroactive to 1/1/2017? Or take effect in 2018? Will estate tax repeal and carryover basis be effective immediately in 2017 or be delayed until 2018? Or will budgetary pressures result in a phase-in over several years like the last time we did this in 2001? 3 4 Will the 16 states that currently have a state-level estate tax repeal their tax? California does not have a state-level estate tax, but Oregon and Washington do. Most state estate tax systems rely heavily on information and structure from the Federal estate tax. States would incur increased costs to continue to impose their own estate tax without being able to piggyback off the Federal estate tax system. Could the Federal estate tax ever come back in future years? Would it then make sense to keep whatever you have already put in place or move as much of your assets as you are comfortable doing to your family now? Things to consider if tax reform passes Married clients will need to revisit their Revocable trusts and wills to determine if they need to be tweaked if the documents have common language about dividing up assets upon the death of the first spouse. Dividing assets at death is and will continue to be very popular as a means to make sure that the children eventually end up with the assets, and that those assets are not transferred to a new spouse or other person after the death of the first spouse. Stories abound about late in life relationships and marriages that end up disinheriting the children. However, dividing assets at the death of the first spouse solely to minimize future estate and generation skipping taxes will not be an issue if the Federal Estate Tax is repealed AND the repeal is permanent. Revocable trusts that divide assets for this latter purpose usually reference the allocation of some of the couple s assets to a Bypass Trust upon the death of the first spouse (this also goes by other names such as Credit Shelter Trust or an Exemption Trust) with certain restrictions on the surviving spouse s ability to use those assets (these restrictions can be narrow or broad). As a side note, clients who are residents of the 16 states that still have a state level inheritance tax may still need to use this strategy even if the Federal estate tax is repealed. Any client dividing assets at death between a current spouse and children from a former marriage needs to review how they set this up. Unintended consequences may abound. For example, David was previously divorced and has two children from his previous marriage. Ten years ago, David married Barbara. David is worth $11 million consisting of their home, $8 million of securities and cash, and a $500,000 IRA where Barbara The PrivaTe Bank 5

is named as the primary beneficiary. Barbara s net worth is $600,000. David s current Revocable trust states that upon his death, the maximum assets that can pass estate tax-free go to his two children and the balance of his estate passes to his wife. Current law in 2016 would transfer $5.45 million to David s children if David died this year. Applying the proposal Federal Estate Tax repeal to the language in David s trust, David s children would get everything except the IRA (David named his wife Barbara as the beneficiary) because the document says the children get the maximum assets that can pass estate tax-free, which is all of it. At that point, Barbara could sue to argue this is not what David intended, but she faces an uphill battle. And meanwhile you now have big ugly litigation. As discussed above, Clients will need to review any advanced estate tax planning strategies they previously put in place, to see if there are still any other benefits that justify keeping them. If not, clients and their attorneys will work to figure out whether to keep or un-do these strategies. If they are lucky, there will be language in the document that allows this, or a state statute that allows this. Otherwise, they will have to go to court and ask a judge to terminate the structure. It is anticipated that if Tax Reform passes, there will be a lot of legal proceedings to undo existing structures. Anyone contemplating large charitable gifts may want to make them in 2016 if the itemized deductions are capped under the Trump proposal. ~ Jayne Hartley Director, Private Wealth Management Union Bank Charitable planning will still be important and popular. The tax benefits of charitable planning will be from the income tax side. In particular, Charitable Remainder Trusts will still be attractive in high income tax states for clients seeking to prevent triggering capital gains on an appreciated asset in the year of sale. Private Foundations and Donor Advised Funds will continue to be used. Just keep in mind that the proposed cap on itemized deductions may limit how much of a charitable deduction you will get in any given year. Income tax planning through taking advantage of tax-deferred vehicles will still be attractive, as will contributions to Section 529 College Savings Accounts. Year-end gift planning: what to do For clients that might pass in the next year or so, it can still make sense to move forward with select estate tax minimization strategies since we don t know what the effective date of any Tax Reform legislation would be and we don t know if any proposed legislation will pass. For all others, it will be up to the client and their attorney to make this call. For example, the recently proposed Internal Revenue Code Section 2704 regulations have many high-net worth clients considering gifts or sales of fractional interests in entities before year end. The downside of taking a wait and see approach is that if these regulations become effective, the window to take minority interest discounts for fractional interest gifts of entities, may close. However, with a public hearing scheduled for December 1, 2016, it appears unlikely that the new rule will be finalized before the President-elect is sworn in, and he has already made very generalized comments that all regulatory projects will be put on hold. Add to all of this the fact that some Republicans in both the House and Senate are currently trying to prevent the finalization of these regulations. Trying to take advantage of minority interest discounts before proposed 2704 regulations take effect is moot if the estate tax is permanently repealed. So, the only real harm in not moving forward with planning is if the estate tax is not repealed. The PrivaTe Bank 6

Additionally, anyone contemplating large charitable gifts may want to make them in 2016 if the itemized deductions are capped at the $200,000 for married couples and $100,000 for individuals under the Trump proposal. Ultimately, it will be up to the client and their advisers to decide whether to move forward with any strategies currently being contemplated, or to wait and see instead. In the meanwhile, it would be good to get organized. Make sure to visit with your local Union Bank relationship manager to begin these conversations before any proposed Tax Reform takes effect. Steps to take before year-end Three possible tax plays should be looked at before year end. First, consider pushing any income, including capital gains, to 2017, if possible. Even if the capital gains tax is not changed, the elimination of the 3.8% net investment income tax could still generate significant savings. Second, accelerate any itemized deductions into 2016 if you can take advantage of them, including payment of real estate taxes on your residence, payment of state income taxes and maximize charitable contributions. Consider creating a Donor Advised Fund which allows you to make charitable donations to a fund so that the charitable income tax deduction is triggered for 2016, but you can actually make the donations to the charities of your choosing in any future year (under current law). The current charitable income tax deduction rules allow you to deduct up to 50% of your adjusted gross income (last number on page one of your Federal form 1040) for cash donations and 30% for appreciated asset donations. We are currently setting up many of these for our clients who want to take advantage of this before year end. Third and finally, if you are a business owner and are looking at making significant capital expenditures before year end, make sure you evaluate whether you will be able to take a 100% deduction for those expenditures in 2016; otherwise, you may want to push them to 2017 to take advantage of the proposed law that allows you to expense 100% of capital expenditures. We can help At The Private Bank, we take our role as your trusted advisor very seriously. We look forward to helping our clients navigate these waters over the next few months, and to help them create strategies to work to accomplish their goals, dreams, and to address their concerns. As part of your Union Bank team, our Wealth Planning group stands ready to help with these conversations and to analyze numbers where needed. We look forward to helping you and if you have not already heard from us, please reach out to your relationship manager. For more information, speak to your relationship manager or visit us at unionbank.com/theprivatebank. The PrivaTe Bank 7

1 2 Details and Analysis of the Donald Trump Tax Reform Plan, Tax Foundation, 11/14/2016 Shier, S. L., & Lavin, B. J. (2016, November 9). Tax and Wealth Planning Implications of a Trump Presidency. Retrieved November 17, 2016, from WealthManagement.com This publication is for general information only. The discussion of any estate planning alternatives and other observations herein are not intended as legal or tax advice, and do not take into account the particular estate planning objectives, financial situation or needs of individual clients. Wills, trusts, foundations and wealth-planning strategies have legal, tax, accounting and other implications. Clients should consult a legal or tax advisor. Views expressed herein are current only as of the time of publication, and are subject to change without notice. Forecasts may not be realized due to a variety of factors, including changes in law, regulation, and tax rates. 2016 MUFG Union Bank, N.A. All rights reserved. Member FDIC. Union Bank is a registered trademark and brand name of MUFG Union Bank, N.A. unionbank.com (11/16)